Protecting your HOA (condo) from fraud and embezzlement
ECHO

We all say that it won’t happen to us, yet fraud, embezzlement and other methods of theft happen daily to both individuals and companies alike. And homeowners associations (HOAs) are no exception. Here are some quick facts about fraud that every HOA should keep in mind:

18 months – The length of time before the average fraud scheme is detected. Generally a quick hit and run scheme will not result in much money for the thief. More often, small amounts are taken over a long period of time, accumulating in massive loss.

Unreliable detection - The most common method for detecting fraud in the workplace is through tips from employees, customers, vendors and anonymous sources. The second most common method is discovery by accident.

Innocent criminals - The typical fraud perpetrator is a first-time offender. In a recent survey, only 7% of defrauders had prior fraud convictions.

I would qualify this by saying that only 7% may have had criminal convictions. Many fraud cases are handled as civil matters that are resolved by Settlement Agreements resulting in restitution payments and confidentiality agreements.
—CondoMadness

How fraud can impact your HOA
But why should homeowners associations worry about fraud? A common belief is that if a management company steals from the HOA, the problem can be easily resolved by suing the company, recovering the funds, and letting insurance cover everything else. This may be true but, depending on the circumstances, it can take years to recover your funds. In the meantime, the HOA must determine how to continue paying the bills and completing projects that relied on the now missing reserve funds. Homeowners will most likely be upset about special assessments to bridge the gap of funds, and banks may be hesitant to lend your HOA the necessary money.

On top of all this, some funds may never be recovered. Your fidelity insurance may have been insufficient; the management company may have folded and is nowhere to be found. The bank may return your principle, but the interest that would have been earned is lost. With all these factors to consider, boards of directors must realize that with fraud, full recovery is rarely a certainty.

Here are some common fraud tactics used against HOAs:

•	Falsified bank statements.
•	Falsified balance sheets.
•	Payments made to vendors that didn’t exist.
•	Exorbitant “consulting” fees paid to people who either did not exist or had no credentials to consult (except for on a fraudulent plan).
•	Payments for highly excessive or unnecessary repairs, amenities, etc. (like buying more patio furniture than would ever fit at the pool).

When fraud occurs in an HOA, boards are left scrambling to try and recover the losses, each member probably having the same excuse running through their minds: “I can’t believe it. He was such a good person.” But it doesn’t have to be this way. By implementing fraud prevention procedures, monitoring association financial accounts, acquiring sufficient insurance, and just generally having an active role in board member duties and responsibilities, your HOA can work to prevent fraud.

The Board of Directors’ role in fraud prevention
Fraud takes both motivation and opportunity. If either is not present, fraud cannot occur. While the board of directors cannot control the motivation, they can control the opportunity.

Many cases of fraud where funds were taken from association accounts may have been prevented if the board of directors had carefully reviewed their financial statements. While serving on the board is a volunteer position (and many board members have families and full-time jobs), the commitment to serve as a board member comes with certain fiduciary responsibilities. And board members must take measures to safeguard association funds and property.

Create a system of controls for financial transactions
The system of internal controls within an HOA’s financial transactions—the checks and balances—either keeps fraud from taking place or allows it to happen. By setting up and using a system where one individual never has complete responsibility for the intake or dispersal of money, the association will be protected from the most devastating types of fraud.

The importance of a system of controls
Let’s take a look at an example to illustrate the importance of a system of controls:

A long-time trusted employee of the HOA, Bob, has authorization to sign checks for the association. Bob makes out a check for $500 to himself or his own phony company, but indicates in the books that the check is voided. Bob then records an outgoing check for an association service, such as the gardener, for $500 more than the actual cost, balancing out the checkbook. Lastly, Bob has to prepare the bank reconciliation, where he can destroy the fraudulent check to himself and mark the fake check to the association service as properly cleared (since the amounts even out).

The problem with this scenario is Bob’s control over each element of the HOA’s financial transaction: he signs the checks, records the invoices, and prepares the bank reconciliations. By dividing up these tasks, an HOA can create an efficient system of balances that not only can catch fraud before theft occurs, but discourage the act in the first place.

Maintaining the checks and calances
After implementing a system of controls, it’s important that each participant fulfills his or her role. Say your HOA has divided the payment process so that Bob must have Susan sign association checks. If Susan signs blank checks, or does not examine what she is signing, the control is useless.

Every check-signer has an obligation to review the documentation supporting the transaction. Each signer should also note his or her review of the documents in the form of a signoff (or something similar) that indicates he or she has verified the check number, date, amount paid, and account coding somewhere on the payment package, and signifies approval of the payment.

Here are some questions your system should address to ensure that all transactions are reviewed:
• Are they in the association’s name?
• Was the work authorized and completed satisfactorily?
• Is the amount reasonable?
• Is this a duplicate billing or payment?
• Adopt Four Policies for Fraud Prevention

Here are four policies that HOAs should consider adopting to prevent theft in their community.

Require two signatures
To reduce the chance of fraud, consider requiring two signatures on all checks—not just the reserves (which the Davis-Stirling Act requires). Although this may be a hassle, it assures that at least two people are reviewing the payments.

If your management company or bookkeeper signs checks for regular bills, arrangements should be made to have a discreet list of those items they are authorized to approve. When there is a great deal of money involved, you may want to consider a specific account for payments made by management with all other accounts limited to board member-only signatures.

Also keep in mind that whenever there is a change in officers or management, your signature cards should be updated.

Use a lockbox for assessment collection
Assessments are usually paid by checks, meaning the board of directors needs to discuss with the bank procedures to ensure that checks are properly applied to HOA’s bank account. Consider using a bank lockbox service to collect your assessments. With a lockbox, homeowner payments are mailed directly to the bank and deposited directly into the HOA bank account. This eliminates unnecessary handling of checks and the opportunity for someone to misappropriate the money coming in. For instance, without a lockbox service the typical check will sit in an accountant’s office, waiting for the deposit slip to be prepared, for the weekly bank trip, or to be picked up by the local delivery person, each of which creates an unnecessary risk of fraud.

Create safeguards for cash receipts
The safeguards over association cash receipts are typically sufficient since cash is infrequently received by most associations. However, if receipts of cash are significant, consider adopting policies for regular cash counts and registers for frequent bank deposits.

If the cash does not go directly to the bank but rather to the treasurer or manager, more oversight procedures should be installed. The person receiving the cash should not be the one signing checks and reconciling the bank account (similar to the scenario described above). The HOA should also create a verification trail that verifies that all the cash received was deposited and credited to the proper owner or contractor account.

In order to avoid complications with cash receipts, your HOA should consider adopting a policy that requires all monies received to be in the form of checks or money orders instead of cash.

Monitor investments
The board should establish a policy for investment of funds that is reflected in the minutes. Management may be authorized to provide instructions to the bank with regard to transfers and investments, but this should be in accordance with the board’s decisions.

Investments must be monitored. The balance sheet should include detailed listing of all accounts, including the name of the depository and, if applicable, the maturity date and interest rate. If your funds are placed outside your main bank through a CD investment program, the coordinating institution should be named as well.

Rather than keeping large (possibly uninsured by FDIC) amounts of money in one or two accounts, consider laddering your funds to match your cash flow needs. Investment terms can range from one month to multiple years. It is much more difficult to gain access to funds that are in a number of timed certificates with varying maturity dates. Many banks and brokerage firms have special programs for these investments that will assure the safety of your funds so that the board does not have to do all of the research into the best rates, etc.

Execute controls on bank accounts
Civil Code Section 5500  requires the board of directors to review the bank reconciliations for all accounts at least quarterly. This includes investments, certificates of deposit, treasury bills, savings accounts and so on, in addition to the checking account(s).  Even if your board of directors has the management company handle the bank statement reviews, at a minimum the treasurer should receive a copy of all bank statements. If your HOA wants to be extra cautious, have all board members receive copies (many banks offer this service).

If the board of directors does not prepare the bank reconciliation, a board member should still inspect the cancelled checks or the copies sent by the bank with the statement. HOAs should also consider having the bank statement mailed directly to a board member who would open and examine it before giving it to the management company, bookkeeper, or board treasurer for reconciliation. This would not eliminate the need to review the reconciliation on a quarterly basis, but it would ensure that the statement could not be altered without notice and cancelled checks could not be removed. Consider doing random bank reconciliations as well, without warning and on an irregular basis, to discourage fraudulent behavior.

Budget comparison
If there is any difference in the month-ending balance between the balance sheet and the actual bank statement, there should be a reconciliation form to explain the differences, generally due to deposits or withdrawals in transit. Any unexplained differences should be promptly investigated.

The Civil Code-mandated budget-to-actual comparison should also show a budget discrepancy as the embezzlement unfolds. The defrauder has to make the cash balance; therefore the money has to be expensed somewhere, and since HOA budgets are usually tight, small differences can be noted and addressed. This comparison needs to be done quarterly so that any problems are promptly addressed and corrected. When associations use these procedures frequently and thoroughly, they discourage potential defrauders by increasing the odds of detection.

Timely reports
The board should receive the association's month-end financial statements and bank reconciliations within the following month. If this is not happening on a regular basis, the board may find itself unable to perform its fiduciary duties. “Within the following month” is not a hard and fast rule, but the reason for the delay should be reasonable—like a change in management. Sometimes at the end of the year, these reports take longer, but preliminary statements should be ready on the regular monthly schedule. Timely reports promote proper vigilance, which in turn can help the board can catch fraud before too much damaged has occurred.

Proper management of accounts
Your HOA should determine who can transfer funds to and from accounts within the bank. Board members should ensure that statements are sent at least quarterly, although US Treasury statements are only sent when there is activity—a purchase, maturity or renewal. Some professionals believe this includes a transfer from one account to another even within the overall category of reserve funds, which is a good, cautious stance. Review the statements for the dollar amount (and the financial statement carrying value is the purchase cost plus investment/interest earnings, not the market value) and for the account title. The accounts should always be in the name of the association, not the manager or an owner or anyone else. If the account is not in the association’s name, then the association does not own it and someone else has control of it and can take it.

Conduct a CPA audit or review
Even if your annual gross income is below $75,000 and a review is not strictly required by the Civil Code, the board should consider having a CPA review done periodically, especially if there has been a change in management or bookkeeping services.

Your CPA will look at your system of internal control during preparation of your annual review and, if you have an audit, will test those controls as well. If you suspect fraud from management or a fellow board member, call the CPA in to look at things early. Association CPAs want to be of service to their clients and dislike seeing anyone get away with fraud.

Review your HOA’s insurance policy
The association board and/or manager should dicuss their policy with the insurance agent, reviewing all of the association’s activities to assure complete coverage under the fidelity insurance (Learn more about the different insurance coverage options for HOAs). Fidelity coverage is often specific about what type of loss will be covered, including how the funds were taken. Here are a few points to cover regarding your HOA's insurance policy:

Who should be included?
Employees
Especially those with access to any type of funds. This also includes those who have authority to purchase equipment and/or supplies for the association.

Managers/management
Your management company should be endorsed onto the association’s bond. The management company’s bond generally covers funds owned by the management company and sometimes funds they are holding for others. Their bond amounts are usually much smaller than the totals in the association’s reserve accounts, especially if they have a large number of clients.

Bookkeepers
If you use a bookkeeper, whether a volunteer living at the association or contracted, that person should be endorsed onto the policy.

Board members
Board members are volunteers, they may not qualify under the strict definitions of the policy as “employees.” Be sure your policy includes an endorsement for volunteer directors.

Committee chairs
Important for any committees that may have access to equipment or supplies.

What scenarios should be covered?
Theft by employees
The major purpose of the bond.

Computer theft
Theft of files from the computer or other uses of the computer to gain access to the bank accounts should be covered.

Theft by outside parties   
This includes physical burglary or robbery. How much money is kept in the association office? Who takes the money to the bank, and what happens if that person is robbed on the way?

Forgery   
While the bank may reimburse for an obvious forgery, remember the earlier statement that most fraud takes place over a long period of time. Banks may only be “on the hook” for a limited amount of time—think of those notes on your bank statements indicating that you must bring up any problems or concerns within 30 to 60 days of the statement.

While it may seem obvious, be sure that your fidelity bond is sufficient. The amount should cover your total reserve funds, plus operating funds. One recommended formula is total reserve funds plus three times your monthly operating income. Be sure that you have taken into account the additions to the reserves that will take place after the bond has been placed for the year. If you settle a large lawsuit or otherwise have a major change in total cash assets, remember to increase your fidelity coverage.

Consider inviting your insurance agent to a board meeting to review these issues. Let the agent know your questions in advance so that he or she has time to put together information about your policies and explain any recommendations.

Adapted from articles by Geri Kennedy and Joelyn Carr-Fingerle. Geri Kennedy is a vice president of HOA operations with Heritage Bank of Commerice. Previously she was a principal at two association management firms. She is co-chair of the South Bay Resource Panel, a member of the ECHO Legislative Committee and a former member of the ECHO board of directors. Joelyn Carr-Fingerle is an accountant in Fremont, CA, with a large CID practice. She is a member of the Accountants Resource Panel, chairperson and member of the East Bay Resource Panel, and a former member of the ECHO Board of Directors.

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